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Fund Flows a Proxy for Market Credit Risk

A new paper finds that “mutual fund flows give an indication on investor risk tolerance and can serve as risk indicators or serve as a proxy for market credit risk.” Looking at fund flows from 2004 to 2014, the researchers found a correlation between the flows of equity and money market fund flows and spreads in the CDS markets, where greater spreads are seen as an indication of higher credit risk.

They found that an increase in equity fund flows corresponds to a decrease in the average CDS spreads. Conversely, inflows to money market funds correspond to an increase in average CDS spreads. However, the authors found that retail investors were the main driver of the effect because they “are generally unsophisticated investors and are more likely to be influenced by sentiment.” The researchers also found that the predictive nature of equity fund flows was stronger in the pre-2008 era, while the predictive nature of money market fund flows was stronger in the post-2008 era.

The Wall Street Journal provides an overview of the paper here